CIO update – making cents of the dollar

If you’ve jetted off to the US on holiday this year, you may have noticed that you received more ‘bucks’ for your bang at the money exchange counter. This would have been because the US dollar has fallen against the pound since the turn of the year.

Announcements from the White House regarding trade policies, tax cuts and rising government debt have raised concerns over the country’s economic outlook. Consequently, the dollar has declined roughly 7% against the pound year to date.

What is most atypical is that equity markets and the dollar have been falling in unison during the most recent periods of volatility following ‘Liberation Day’.

Historically, investors turn to the US dollar as a safe haven during turbulent markets given its status as the largest economy in the world, the deep and liquid US treasury market, and the stability of the US economy relative to many global peers. Since the 1970s, in each period that the US equity market declined by more than 20%, the US dollar rose on average 5% against the pound. This scenario has historically helped UK investors mitigate some of the losses on US assets once converted back to pounds. Although the dollar did not provide its traditional safe haven status during the market weakness from February to April, which was driven by the trade war emanating from the US. However, if we were to see a global recession, the safe haven status of the dollar may reassert itself.

Past performance should not be taken as a guide to future performance. The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. You should continue to hold cash for your short-term needs

Overweight sterling

It’s worth noting though that these currency fluctuations have caused headwinds overall for sterling-denominated portfolios. Despite equity markets rallying for the past two months, because the dollar has been declining, returns for sterling-denominated portfolios have been lower once converted into pounds.

In January, before the slide of the dollar took full effect, our investment process guided us to move overweight the pound versus the dollar within portfolios. We identified that the pound looked undervalued following several months of depreciation in the second half of last year.

As a result, we hedged some of our US equity allocation to pounds. This has benefited the performance of our portfolios compared to our benchmark, as detailed in the graph below.

Over the long-term, we would expect the performance of assets such as equities and bonds to be more important than currency market fluctuations. Assets such as equities and bonds tend to benefit from compounding over time – when investment returns are reinvested and are able to generate further returns. In contrast, currencies tend to mean revert. While a declining currency may impact a portfolio’s total returns in a given year, over a longer time horizon, equity market performance – driven by earnings growth – could have a larger influence. 

We design our client portfolios to be diversified to help mitigate against a range of risks. This is particularly vital at the moment given the level of uncertainty surrounding the global economy. Geopolitical events such as the recent escalation of the conflict between Israel and Iran can impact markets, therefore our active diversification, beyond equities and bonds, can be a valuable way of potentially protecting portfolios from such shocks.

Diversification through currency exposure is just one technique we implement to manage the level of risk our portfolios are exposed to. Our strategy is global in nature, and so our currency strategy is no different with allocations to euros and the Japanese yen as well as the dollar and the pound. 

Speak to us

If you are a Coutts client and would like to discuss market developments or your own investments with us in more detail, please contact your private banker.